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Thursday, July 28, 2011

Day 287 - Student Loans 101: Basic Concepts

Student loans are a large percentage of many people's total debt burden. I wish the answer to paying off debt was as easy as saying 'just don't use student loans', but many (including myself) don't have many other options if they want to attend school. If you have exhausted all resources for scholarships, grants and work study, you will need to educate yourself on the ins and outs of student loan lingo. Below is a brief explanation of student loan phrases you will encounter often. I have attempted to do a clear and concise summary. My information came from Federal Student Aid, an office of the US Department of Education. There is a plethora of information on this site including many very helpful publications to read. Make sure you do additional research prior to making any financial decisions related to student loans. My explanations below are merely a starting point.

Subsidized vs. Unsubsidized: If you have a subsidized federal loan, the federal government pays interest while you are in school at least half-time and during grace and deferment periods. An unsubsidized loan, on the other hand, accrues interest from the time the funds are disbursed to you. You are responsible for paying that interest. If you choose not to pay the interest while you are in school, the interest will accumulate and be added to the principal balance of your loan. If you let the interest capitalize, you will then pay interest on the increased loan principal amount (essentially paying interest on interest!!).

Federal Loans vs. Private Loans: Generally, federal loans have lower and fixed interest rates, general repayment plans and no prepayment penalties. Private loans usually have higher, variable interest rates that could substantially increase the total amount you repay. Some private loans also have prepayment penalty fees. Warning: Private loans can be aggressively marketed to students - make sure you have considered any federal student loans you may be eligible for prior to taking the private loan route.

Deferment vs. Forbearance: A deferment is temporary postponement of loan payments if you meet certain requirements. During the deferment period, the government will pay the interest on subsidized loans, but you are responsible for any interest that accrues and is eventually added to the principal balance. The most common loan deferment conditions are enrollment in school at least half-time, inability to find full-time employment, economic hardship and military service.

Forbearance allows you to postpone or reduce your monthly payment amount for a limited and specific period if you are willing but unable to make your scheduled loan payments for reasons that include financial hardship AND you do not meet the eligibility requirements for deferment. WARNING: Interest will continue to accrue during the forbearance period, even if you have a subsidized loan. This interest will be capitalized and ultimately increase the principal balance when you resume making payments.

Repayment Options

Standard. If you do not choose a repayment plan when you begin repayment, you will automatically be placed on the standard repayment option. Fixed payment for up to 10 years (up to 30 years for consolidation loans). Payment must be at least $50 per month.Graduated.This plan is tailored towards those with low current incomes (recent college graduates) who expect to have their incomes increase in the future. Payment period up to 10 years (30 years for consolidation loans). Payments start out low at first and then increase about every two years. The minimum payment must at least cover the interest that accumulates on the loans between payments. Result: You will end up paying more for your loan compared to the Standard Plan because more interest accumulates in the early years of the plan when the outstanding loan balance is higher - so most or all of your early payments will only go towards interest.Extended. You must have at least $30,000 in outstanding loans in either the FFEL or Direct Loan programs (you can't combine the two balances). Payment period is 25 years and monthly payments can be either fixed or graduated. Result: You will ultimately end up paying more because of the interest that accumulates during the longer repayment period. Income-Sensitive Repayment Plan. This repayment plan only applies to FFEL loans. The maximum repayment period is 10 years and the monthly loan payment is based on annual income. Result: As income increases or decreases, so do payments.Income-Contingent Repayment Plan (ICR).Applies to Direct Stafford and PLUS Loans but is not an option for parent PLUS borrowers. Under this plan, the repayment time frame is 25 years - any remaining balance after 25 years will be forgiven. Monthly payments are determined based on annual income, family size, and your total amount of loans. Result: You may have to pay income tax on the amount that is forgiven.Income-Based Repayment Plan (IBR).Applies to Direct and FFEL Stafford/PLUS loans. Parent PLUS loans are not eligible. Similar to the ICR, your repayment period is 25 years with the remaining balance forgiven when the time period is over. Monthly payments are capped at 15% of discretionary income and you must have partial financial hardship to enroll. Interesting Note: If you are married AND file taxes separately, only your income will be considered when calculating your IBR payment. Result: Similar to ICR, you may have to pay income tax on the amount of the loan that is forgiven.
Now that you have become familiar with a few key concepts related to student loans, what other questions do you have related to the student loan process? Leave your comments!

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comments:

If you have both federal and private loans or undergraduate and graduate loans it can make sense to use the graduated repayment plan for the federal/undergrad loan and pay extra to the private/graduate loan. In my case it will save us money compared to paying everything on the standard repayment plan.

I just feel for those of you in the USA. You have to pay so much for your education. In Canada our education is affordable and our student loans are not hard to pay off once your done. I guess it's a matter of government policy and accessibility.

Great post on the different types of student loans. What most people forget is that the collateral for student loans is your personal earnings. They can't be discharged, and the government can and will garnish your wages if you don't pay them back. In fact, I recently read an article about someone who is having their Social Security garnished for student loan debt.

Sounds like a good plan. If I'm understanding correctly, this would allow for a smaller payment on the federal/undergraduate loans in the beginning. That way you would be able to throw more money towards the private loan (which typically has a higher interest rate).

Sounds like a good plan. If I'm understanding correctly, this would allow for a smaller payment on the federal/undergraduate loans in the beginning. That way you would be able to throw more money towards the private loan (which typically has a higher interest rate).

Robert, you bring up some excellent points. With the exception of a few career tracks, student loan debts are pretty much there until you pay them off. If you get a chance, send me the link to the article you are talking about - would love to read it.

I didn't know there were so many options. When I still needed money after scholarships and part-time jobs, I took loans from my parents at 5% interest ($8000 by the end of school), but I was lucky - my parents forgave the loans after a couple of payments after I graduated.

A very comprehensive and informative post about student loans! Great Job!

I still have around $19,000 to pay for my student loan but it is manageable and I have taken advantage of the automatic payment to get an additional discount rate. I think it was around 0.25%. As of now, I lucked on the interest rate as I was able to refinance it back then when the interest rates was really low.

Ken, I was able to consollidate a while ago and get a 3.625% interest rate on my undergrad loans. Since it's so low I wonder if it is worth it to still pay off? It's will be the only loan we have left after The $60K Project.